A. Precious Metals prices spiraled up in 1H11

The gold price spiraled up in 1H11, increasing 5.5% from US$1421.55/Oz at the end of 2010 to about US$1500/Oz in late June. Though far less than the increase of 29.56% in the whole 2010, the rise of gold still led many other financial assets. The main rise had occurred between February and April, when the USD depreciated for the QE2 and the European sovereign debt crisis became worsening. However, gold price has lingered around US$1500 since May, presenting the outstanding status of precious metals.

What's more, the silver's performance deserves more attention. Benefiting from its commodity and finance attributes and the small market capacity, silver price surged to US$50 in late April, a historical high, which was also 55% higher than that in 2010. However, the U.S. then improves the margin of silver futures to refrain the speculation, silver price has plunged about 30% since May and maintained at about US$35.

Compared to the slight rise of gold price, some gold stocks experienced the plunge after early rise. At last, only G-Resorces（1051.HK） and Zhaojin Mining（1818.HK） got the return below 4%, which was still behind than the gold. Others performed worse. Zijin mining（2899.HK） declined 17% because of the pollution incidents. Real Gold Mining(0246.HK） plunged 34% for the doubt on its financial data and it is still in suspension. Lingbao Gold （3330.HK）, the stock with the largest rise in 2010, has also lost 30%. In our view, the weak gold sector was negatively influenced by the weak stock market. For example, the HSI index decreased 2.8% in 1H11.

B. Gold price rise may speed up in 2H11

1. Gold supply maintains stable

According to the report by the WGC, the total gold supply declined 4% y/y to 872.2 tons in 1Q11. The gold mine production and net producer hedging contributed to the supply actively, but they can`t offset the decrease of the official sector sales and the recycled gold.

In 1Q11, the gold purchase by the official sector reached up to 129 tons, above the total of first third quarters in 2010. Mexico, the main buyer, purchased 93.3 tons. The official sector has changed from the net seller to the net buyer of gold since 2010. What's more, the recycled gold was only 347.5 tons in 1Q11, the lowest since 2010. Nowadays, both the government and the people are taking strong interest in the gold. In our view, the trend will continue in the era of deteriorating paper credit.

It is also noteworthy that the output of mineral gold increased y/y to 664 tons in 1Q11, but the global gold mines have a short available mining term, only about ten years. In addition, only a few gold mines have been newly found in recent years. Therefore, we don`t think the prospect of mine-produced gold production is optimistic. As a matter of fact, the output of mineral gold hadn`t increased basically, which was respectively 2623 tons and 2689 tons in 2001 and 2010.

2. Gold demand increased steadily

Global gold demand comes mainly from consumer demand and investment demand. Entering into the 21st century, especially since global financial crisis in 2008, the investment demand drove by hedging risk and value protection has realized significant increase from zero in 2000 to nearly 1500 tons, which accounted for 30%-40% in the total demand. The highest was 57% when global financial crisis was in the darkest days. Recently, the proportion of investment demand has been above 30%. On the background of high inflation expectation and currency war, we think the investment demand will keep high.

What's more, the consumer demand of the gold still shows strong. Firstly, the suppressing effect by rising gold price has become weaker. In contrast, the gold has seen both the rising consumer demand with higher gold price. The consumer demand had increased to 2483 tons in 2010 from 2223 tons y/y despite over 75% increase of gold price since 2009. In 1Q11, the demand recorded the new high of 690 tons, with quarterly 4.55% increase.

Secondly, the consumer demand also faces the chance from emerging economies including India and China. Generally speaking, economic growth can bring about gold consumption. In 2010, the GDP per capita was respectively US$1367 and US$4371 in India and China, but their gold consumption per capita was only about 0.4g or below, indicating that there are still sound growth space. In reality, China's demand for gold ornament increased 21% y/y to 143 tons in 1Q11, setting a new quarterly record.

3. The money supply will still be adequate

To guard against ascending inflation pressure, the EU and major developing economies have put forward tightening monetary policies continuously. For example, the PBOC and the European Central Bank have raised the benchmark rate two times synchronously, which can partly slow down the worry over flooded money. However, they have injected huge amounts of money into the market since the global financial crisis, and the consequence hasn`t come out fully. In future, China may plan to slightly loosen the monetary policies, and the Europe may still make more liquidity to save its sovereign debt crisis.

What` more, though the U.S. has seen steadier real estate market in the bottom and slightly improved business loans, they have been both realized on the background of quantitative monetary policies and are still at the bottom. Moreover, the inflation indexes and the employment situation deserving more attention are still facing high pressure, and the latest unemployment rate has increased to 9.2% m/m in June, higher than 9.1% in May and recording the highest level since December 2012. In our view, it is of high possibility that the Obama administration facing the 2012 Election will put forward the QE3 or similar policies to maintain easing monetary situation. Moreover, the U.S. is still burdened with US$14.29 trillion public debt and US$115 trillion unfunded liabilities, but its annual GDP is less than US$15 trillion. Therefore, the U.S. is even facing more severe debt pressure than other economies, and it may continue to print more dollars to let the USD depreciate, which may bring about the debt monetization and stimulate the export, and then alleviate its debt burden and benefit the economy. Therefore, the factors including easing money and depreciated USD will still underpin gold price in future.

4. The inflation bell may be tolled in medium to long term

Among global major economies, nearly all have experienced constantly rising CPI since 2010 except that Japan is still facing zero inflation because of long-term economic downturn. For example, the CPIs of the Euro Area and the UK have broken through their target zones, China has also adjusted upwards the inflation target to 5%. In our view, global economy may face a new round of inflation peak on the background of flooded money.

Firstly, inflation represents a monetary phenomenon. Major economies like the US and China recently have printed the money at no allowance, intending to resolve the economic structural imbalance with more liquidity. The U.S. money supply has increased by almost $1 trillion in just the last three years, the greatest three year increase of money in the history of the world. Meanwhile, China has injected RMB 36 trillion into its economy since 2008, which enlarges the money balance of 89%. Plus with huge printed money in the EU and Japan, we think all those will drive up higher prices and asset bubble.

Secondly, the USD depreciation may still be important drive for the prices of major commodities in medium to long term.

Thirdly, we think global agricultural products supply should be concerned. Currently, the rates of inventory to consumption of many agricultural products like corn and sugar stand at a very low level. Furthermore, due to global greenhouse effect, unsteady climate has become hackneyed. Therefore, the supply of agricultural products may be negatively influenced, and their prices may rise unexpectedly.

Lastly, we also pay attention to possible cost-driven inflation by rising labour cost. Presently, only India's population structure is young, other major economies are falling into the ageing tendency, and the labour force may become scarcer.

Therefore, we worry about the inflation since 2011. Benefiting from the character of value protection, we think the gold will catch investors` eyes. What's more, it is also noteworthy that it is when facing high inflation and low Fed rate that international gold price has surged in past fifty years. Between 1971 and 1980, the U.S. had seen negative real rate in nearly ten years, with the lowest rate at -5.6%. Plus with the disintegration of the Bretton Woods System, gold price rose from US$38.44 to US$850, setting a historical high. Nowadays, the U.S. has fallen into the dilemma of negative real rate since October 2010 endlessly, and the lowest rate was -3.9%. What's more, international financial system may be also in the reconstruction. Therefore, gold price has increased over 400%. In our view, it is little possibility that the U.S. can go out of the negative interest rate in short term, and the momentum underpinning the gold price is still strong.

5. Debt crisis and geopolitical conflict may propel hedging demand

One of main factors supporting gold price in past two years is the sovereign debt crisis triggered by Greece. It has occurred two times. The first had broken out between December 2009 and June 2010, and the second has begun since March 2011. The main effect is that the USD and gold price ramp up synchronously for hedging demand after the debt crisis erupted when the USD had been close to the low in 2008.

In the latest sovereign debt crisis, besides some European countries like Greece have been adjusted downwards the rating, other major economies like the U.S., the U.K. and France have also been warned, so the debt crisis shows the spreading sign. Though the debt crisis won`t break out on a large scale in short term, it may explode discontinuously because the lack of effective and essential measures to resolve the crisis in major economies. Therefore, gold price can be underpinned constantly. For example, after Greece had won the relief funds, the rating of Portugal was lowered to junk recently, and the prospect of Spain also seems not optimistic. If the sovereign debt crisis of the two countries becomes worsening, the influence will be much larger than that triggered by Greece.

What's more, we believe global game is still worsening with the evolved international situation after the international financial crisis, especially in this year. Firstly, the international finance and the monetary system are still in the reform and present unsteady, which can be seen in the foreign currency conflict. Secondly, the Palestine-Israel conflict in the Middle East may break through in 2011. Many countries in South Africa have recognized the Palestine as an independent country, and the Palestine plans to request for the national founding by the United Nations in September. However, the US and the Israel are insisted on their own idea. From this prospective, the Middle East may face more aggravated conflict. Thirdly, other factors like Iran nuclear crisis are exacerbating the conflicts, and some countries are in unstable state one by one. Considering above risks, we think the hedging character of the gold will be accepted widely.

6. The monetary status maybe return partly

The monetary status of precious metals has been concerned again. The USA had adopted the US dollar instead of the gold as the monetary status in 1970s, but the Utah state has passed a legislation that would allow gold and silver coins to be used as a legal tender in March 2011, which has begun recovering the currency status of precious metals. In our view, gold and silver can`t fully act as the currency for their short supply, but the paper currencies have eroded their credit status for the overissue, so future international monetary system may adopt metals to restrain the overissue of paper currency again, then rebuild up the credit basis. In conclusion, it is not nearly impossible that the monetary status of precious metals return partly. From this perspective, the value of precious metals hasn`t been presented fully.

7. Gold price rise may speed up

International gold price has rose for ten years and recorded new high in past two years. Basing on above factors, we think the gold can keep on the bullish trend. It is of high possibility that gold price rise maybe speed up, because of possible QE3 by the U.S., deepening sovereign debt crisis and worsening geopolitical conflict.

For the target price of gold, we refer to two methods. Firstly, the highest US$850/Oz in 1980s is equivalent to current US$2200/Oz. Secondly, converting global base money M1 to the stock of gold, the price can be US$4100/Oz. Therefore, we think gold price will reached US$1800/Oz undoubtedly in two years, and it is of great likelihood that gold breaks through US$2000/Oz.

C. Active investment into gold stocks

The weak market and tightening monetary policies have suppressed the performance of gold sector. However, looking forward into 2H11, we are still optimistic about gold stocks on the judgment of higher gold price and possible slightly easing monetary policies. For the valuation in past 18 years, we find out that the P/E of XAU index has significant premium over that of SPX index, and the average premium is as high as 149%. Meanwhile, the P/E of gold stocks listed in HKSE has also been higher than that of the HSI. For example, the average P/E of Zhaojin Mining and Zijin Mining have respective 84% and 97% premium. For Lingbao Gold with small scale and lower gold reserve, its valuation premium is 21% in average. Currently, their valuation premium is respectively 159%、32% and -2%, the low level in history.

Regarding gold stocks, we think Zijin Mining and Zhaojin Mining are worth paying attention. Now the valuation premium of the former is at historical level. The negative effect of its pollution incidents has been digested largely. Moreover, many of projects under construction will be put into operation between June 2011 and June 2012, the Company is expected to enter into a new round of rapid growth. Meanwhile, Zijin Mining may also prepare to invest in minor metals resources, which will face optimistic prospect. Regarding the latter, as the leader of gold stocks, Zhaojin Mining can more benefit more from rising gold price.

In past two years, the performance of the small and medium cap gold stocks has been sluggish. However, the companies with high growth or increasing resource reserves have won better performance. Therefore, we recommend China Precious Metals（1194.HK） and China Gold International Resources（2099.HK）. The former's core developing strategy is to actively acquire gold mineral, and its gold resources may increase to nearly 300 tons in 2011, a middle level in peers. Meanwhile, the newly acquired mines are convenient to develop and of low-cost advantage. Regarding the latter, it is backed by China National Gold Group (CNG), and it can take strategic acquisitions sourced from the international project pipeline of the Group. What's more, it is also worth noting that many small and medium cap gold stocks experienced the plunge of about 30% in 1H11, but we think they are the victims of weak stock market. Therefore, it is of high possibility that those companies can realize the value return.

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